Can the CFA do for ESG what it did for investment performance standards?

Just over 20 years ago, CFA Institute, the global association of investment professionals, internationalised the Global Investment Performance Standards (GIPS), which became the de facto methodology, solving the problem of diverse country-specific methods of reporting investment numbers.  

Now, CFA Institute is developing an ESG disclosure standard for investment products, with an expected launch in May 2021.

RI spoke to Gary Baker, Managing Director of CFA Institute Europe, Middle East and Africa (EMEA), about how this work on ESG standards could look and evolve.

Baker previously held roles including Managing Director, Deputy Head of Research, with Jefferies, the boutique investment bank, and as Managing Director, Chief European Equity Strategist at Merrill Lynch. 

RI: In the CFA Institute’s announcement on its planned disclosure standards Margaret Franklin, President and CEO, said: “In the face of growing interest in ESG investing, we found widespread support from the investment community for the development of a standard to reduce confusion and facilitate better alignment of investor objectives with product intent.”

Can you elaborate on the CFA Institute’s thinking here and the problems outlined? 

Gary Baker: Following discussion with members, we’d been looking at the areas where we felt there was confusion and alignment issues. And when it came to actual investment products we felt there was a glaring hole. If you're saying you're ‘doing this’ and that it is the nature of your investment product, then what is the evidence that investors can have some confidence in that? We’re not trying to define the lexicon of ESG. Clearly, there's a lot of work going elsewhere on that subject. We're trying to represent an investor viewpoint. If a fund says it is ‘green’ how are we actually going to demonstrate that, or give people a degree of comfort that it is indeed the case? Anyone can come up with a standard. But are you prepared to stand behind it and enforce it? If not, who will? And how? We’re trying to raise that level of debate and commitment. 

RI: How different is this then from what's being asked for under disclosure of the EU’s Sustainable Finance Action Plan, or within the US debate around ERISA rules for asset managers to disclose what they're doing with ESG? Will you be setting standards to accompany the regulatory initiatives out there, or acting as assurer?

GB: With GIPS, we are the standard setters. We haven’t got involved in the assurer and implementation aspect. We are open minded at this point as to whether that will be the same procedure we adopt with ESG standards. We’ve had a lot of calls asking if we are going to get involved in that aspect of it? Whether we do so directly, or look at models where we provide a license or list of accredited assurance providers or something like that, we haven’t ruled anything out or in yet. At the moment, it’s the actual industry ‘acceptance’ that you need. We're not the only organisation engaged in this pursuit of transparency. An ‘exposure draft’ will probably be the next iteration, and we’re setting up a couple of volunteer committees on technical matters and assurance. If you launch a standard, you have to make sure it stays up to date, or if it’s an assurance-type programme you have to make sure it is looked after and people adhere to it rather than just pay lip service.

RI: How similar is this to GIPS, where there was a clearly definable problem with a relatively clearly definable solution? In many ways here, you're talking to some extent about strategy and belief rather than hard data.

GB: Well, I think to an extent, yes, belief is an element. But I think one of the intentions here is to try and not necessarily isolate that variable; because there is a spectrum of where you might be positioning a particular investment. It might be purely exclusionary, or at the more philanthropic/impact investing end of the scale. But at any point along that scale, you should understand where you are positioning that investment and an investor should feel confidence in that.  

We think there is a definable problem. But is it as clear-cut in terms of solution? We think elements of ESG might fit standardized representation. But as it gets more and more embedded into the regular business of investment analysis, you could argue that a standard may ultimately be redundant. We are pretty confident though that there is an unmet need in terms of product claim description. 

RI: It's almost a definitional problem?

GB: In some ways it is. There's quite a few funds that have already approached us to get engaged because they're looking for clarity. How do they position themselves in a crowded marketplace? It’s necessary, because the funds business has, of course, a hugely pragmatic, commercial drive and will work out a way in which they can say, yeah, this is what we are… 

RI: As an experienced senior investment research analyst, what's your sense of the validity of ESG data out there and its relevance to investment decision making today?

GB: It's fascinating, isn't it? I was a real estate analyst for years and there are certain aspects of core ESG governance: abuse of tenants, degree of leverage, that you'd be absolutely incorporating into every aspect of analysis. But at the point I was writing research I wasn’t thinking about the carbon footprint of supply chains or how much of a building could be recycled or what was the sustainability of the end product. If I was writing that research today, I would clearly be incorporating the E aspect into it. I can't imagine how you're writing research now without thinking more about governance or social aspects; interaction with customers/employees, etc. What's different now is it's been extracted and put into a block rather than just incorporated. We've done almost a reverse research process on it. But there's no doubt that the climate/environmental aspect has not been easily embedded within mainstream analysis. I can remember trying to hire SRI analysts back in 2000-2003 to take this seriously, but hardly any analysts would do that, because at that point to them it was not material. There were far bigger factors that affected valuation. And I think that's still the equation to a large extent. But you can't just ignore it. You've got to do the work to understand what the risk attached is. It's a nuance where you need to gauge a reasonable timeframe in which a cost can be put on that could affect your evaluation. That is incredibly difficult. But, it’s an issue corporates face because of regulatory/consumer pressure, and so it's inevitable it impacts on one of the factors in share price movement, etc. There’s almost a degree of self-fulfilling prophecy to an extent. And that makes it even more important that analysts do not ignore it. The regulatory landscape is evolving fast in in Europe and in the US there is a robust conversation happening between the SEC and investors where something like 95% of responding asset managers were negative on the SEC’s proposed rule changes on ESG (See RI story here)

All that is going to continue, obviously, through the US presidential election.   

RI: How much attention do you think the asset management industry has paid to what's happening here.

GB: Sometimes the finance industry’s collective response to regulation will be to push back and deny until the moment where it becomes obvious it's going to happen. And then the pace of change is extraordinary because in the background, a lot of change has already been going on. It’s like MIFID. For all the prior declarations, when it was enacted it was remarkable how swiftly a lot of companies were able to move their trading reporting, etc, because they'd done the work. The industry doth protest too much sometimes. On ESG though, I don’t think this has been so much the case, and I think we are seeing a huge shift.

The challenge though today for corporates – and that includes asset managers – is to have confidence that you can defend your whole supply chain, especially if you are making a stand on an issue. You're as strong as your weakest link. The investing public wants to know this information, and regulators are in favour of more transparency. It's a lot of work in allying this with business models. But, in a social media enabled world, you might be one story away from explosion. 

RI: How do you see the evolution of investment product that meets both financial and sustainability criteria?

GB: There are very, very few asset managers I talk to today that are not engaged in preparing new product launches. Those funds deploying ESG criteria want to mobilize that story. Others are reacting to a commercial reality that you have to be a participant in that space or have a good reason to stay within your swim lane. Either way, you've got to be ‘intentional’. And more so, of course, the closer you get to the impact investing end because it's a lot more hands on.

Some regulators we’ve spoken with focus on fund managers going through their Know Your Client (KYC) requirements and clearly defining products. Others are a bit more activist and engaged in trying to move the industry to be a positive sustainability influence.

This makes it difficult in trying to strike a global standard. I think that that is still going to be one of our big challenges, 

RI: Why do you think we are seeing such a swell of ESG activity in investment?

GB: There's not a single answer. I think it's partly the active v passive debate. ESG should be fertile ground for active managers, i.e. if you feel that you've got a better mousetrap than others or a better methodology and way of approaching it. There is also definitely an investor shift out there. It's a younger investment base with a different value set. If you're an investment company then you're looking at your future demand cohort and you may have to pivot to embrace that.

RI: We're also moving into a much more individualized system of retirement saving…

GB: Yes, there's an atomization of demand where clients want a solution for them rather than just participation in a fund where they’ve been assigned a risk rating. They feel that they want to have a greater say in what their portfolio looks like.

RI: Is there a sense that a sustainability underpinning to investment can encourage more retirement saving?

GB: I think there are two aspects there. One is that there is definitely a requirement for more saving, especially in a “lower for longer” interest rate environment. But it also goes hand in hand with a financial literacy challenge. We get so many requests from governments and regulators for help with financial literacy from high school level up through the workplace, because that's where I think governments see the Achilles Heel in the whole defined contribution pensions shift, which puts the onus on the public. We need to ensure that we are not storing up a huge generational problem for 20 years time.

RI: What other ESG work is in the pipeline at the CFA Institute?

GB: One of the interests for me – and in some ways the privileged position we have at CFA – is to see the global nature of this discussion. It’s fascinating to see what’s happening in Europe, Australia, the U.S., Canada, India, China, and to try and work out the common elements in the different speeds and direction of travel. We’ve got a big piece of research coming at the end of this year on the future of the investment professional, and we're trying to put a sustainability angle and overlay to that. And we've got a big report on climate investing coming at the end of September, looking at it from the practitioner perspective of what is actually going on in the real world as opposed to an abstract concept.